Non-recaptured 1231 Losses & Death

Husband incurred a net Sec 1231 loss in 2019. He filed a joint return with his wife. In 2020, Husband died. There were no Sec 1231 gains or losses in 2020.

If Wife has a big huge Sec 1231 gain in 2021, will any part of it be treated as Ordinary Income under the 5-year look-back rule for non-recaptured 1231 losses?

I don't know but I'm willing to guess. My guess is the lookback rule does not apply to the wife in 2021 because she is not the taxpayer who incurred the 2019 1231 loss.

I don't know but I'm willing to guess. My guess is the lookback rule does not apply to the wife in 2021 because she is not the taxpayer who incurred the 2019 1231 loss.

That would be my guess, too, but I think we need more facts. What generated the husband’s 1231 loss in 2019? Was the property or business jointly owned? Did this occur in a community property state? What generated the wife’s 1231 gain in 2021?

I’m particularly interested in finding out whether the wife was deemed to have incurred 50% of the 2019 1231 loss or whether the husband was a “predecessor.” The Conference Committee Report for the Tax Reform Act of 1984, which enacted 1231(c), says this:

Under the conference agreement, net section 1231 gains will be treated as ordinary income to the extent of unrecaptured net section 1231 losses of the taxpayer (or predecessor taxpayer) for the 5 most recent prior years beginning after December 31, 1981.

Was the property or business jointly owned?

No. Property giving rise to the 2019 loss was solely in husband’s name. Not a community property state. The 1231 loss came through on a K1, the ownership of which was titled in husband’s name only. 100% of that asset showed up on husband’s 706. The partnership issued a final K1 for 2020.

What generated the wife’s 1231 gain in 2021?

She sold a rental property.

or whether the husband was a “predecessor.”

The word “predecessor” is typically associated with entities, not individuals. I don’t see how an individual (wife) could be the successor of her deceased husband (predecessor). If that was the case, then that means husband never died (for 1231 purposes).

I don’t see how an individual (wife) could be the successor of her deceased husband (predecessor).

I do. If the rental property that the wife sold was jointly owned before the husband's death, then the IRS might argue that some portion of the gain should be treated as ordinary income recapture under 1231(c) because the wife acquired ownership of the property upon her husband's death. I don't know of any case or ruling where this was argued, but it might be a viable argument nevertheless.

You are arguing that the husband’s 1231 loss on the jointly-filed 2019 return escaped the 1231(c) recapture rule upon his death, but I don’t see anything in 1231(c) that supports this. 1231(c)(2) says that you look at 1231 losses claimed for the 5 most recent preceding years. It doesn’t say that you only look at one spouse’s losses on a joint return.

1231(c)(2) says that you look at 1231 losses claimed for the 5 most recent preceding years. It doesn’t say that you only look at one spouse’s losses on a joint return.
It also doesn't say you look at my loss or your loss or Jeff's loss. It means the taxpayer's loss, which, per OP, was husband's.

Joint returns don't change who had the losses. They change hown they are taxed.

It also doesn't say you look at my loss or your loss or Jeff's loss. It means the taxpayer's loss, which, per OP, was husband's.

Joint returns don't change who had the losses. They change hown they are taxed.

Where in 1231(c) does it say "the taxpayer's loss"? If that were true, then spouses could file a joint return and report a 1231 loss attributable to one spouse, then a couple years later when the other spouse had a 1231 gain, they could file a joint return and avoid the 1231(c) recapture.

I'm not convinced that death extinguishes the recapture in this situation. I still believe that the IRS could make a viable argument. I'm not saying that you can't argue it the other way. You could. There's just no guidance to prove how this works one way or the other.

How would OP's facts come out if we applied the principles behind reg. 1.172-7 and Rev Rul 74-175? (Not saying that reg. or ruling applies, just asking for comparison).

For that matter, how would this come out if H had lived, but H and W filed MFS in 2021? Again, see 1.172-7. There's always planning around whether to file jointly or not.

How would OP's facts come out if we applied the principles behind reg. 1.172-7 and Rev Rul 74-175? (Not saying that reg. or ruling applies, just asking for comparison).

You may have a better argument under Reg. 1.1252-2(b)(2). I'm not saying that this reg. applies, just pointing out the comparison.

Where in 1231(c) does it say "the taxpayer's loss"?

Ok then, if my brother has a Sec 1231 loss in Year1 and then you have 1231 gain in Year2, you have to recapture my brother’s loss. That’s based on your understanding of things. After all, if the Code Section doesn’t say “the taxpayer’s loss” then we’d have to recapture anyone’s loss. Not sure why you’d limit the reach to a spouse’s loss on a joint return. Hence Nilodop’s comment about “my loss or Jeff’s loss.”

If that were true, then spouses could file a joint return and report a 1231 loss attributable to one spouse, then a couple years later when the other spouse had a 1231 gain, they could file a joint return and avoid the 1231(c) recapture.

Not likely. Your example doesn’t involve a death. But playing along, if we’re talking about a capital loss carryforward by Unmarried Person #1, who in a subsequent year gets married to Unmarried Person #2, and #2 separately has a capital gain in the year of marriage, and they file a joint return in the year of marriage, it all gets netted. This is a function of the “combination” aspect of a joint return, as per Regulation, when it comes to capital losses. But this is not the issue at hand. We are talking about the possible expiration of a tax attribute when the taxpayer expires.

If the cap loss carryforward parallel is appropriate for the 1231 situation, then in your example, we’d have netting all the same. The concept of “whose loss is it?” doesn’t matter on a joint return. The joint filing trumps what would otherwise be separate losses. Now, if they file separately in the year of the marriage, #2 would get no benefit from #1’s capital loss carryforward. In the same vein, if we change the facts so that #1’s capital loss carryforward is instead a prior 1231 loss tax attribute, that would get pulled into the marriage and would be subject to recapture on a joint return even if the 1231 gain was solely attributable to #2. Again, this a function of the “combination” aspect of a joint return, assuming we’d apply capital loss logic. As Nilodop says, this doesn’t change whose loss it was. That inquiry merely becomes moot on a joint return. Again, your example doesn’t involve a death. When we insert a death, then the “whose loss is it?” inquire becomes highly relevant. At least it does when figuring out capital loss carryforwards.

I still believe that the IRS could make a viable argument.

I think any argument they make would be tongue in cheek.

I am not aware of any rule that says filing a joint return of income tax causes the income and deductions of one spouse to be considered the income and deductions of the other spouse. Accordingly, I don't see why the 1231 losses in the OP are carried over to the surviving spouse.

Publication 544: "If you and your spouse once filed separate returns and are now filing a joint return, combine your separate capital loss carryovers. However, if you and your spouse once filed jointly and are now filing separately, any capital loss carryover from the joint return can be deducted only on the return of the spouse who actually had the loss."

In Op, all we are told is that wife had a big huge capital gain in 2021. Was the property (a) hers from the start, (b) hers by inheritance form husband, (c) hers by gift from husband, or (d) hers in some other way? What I'm getting at is the "predecessor" languabe cited above. There might be a plausible argument that H was predecessor in some of those, but not in (a), in my opinion.

And what if H did not die but they file separately in 2021 with the explicit intent of avoiding 1231(c)? I think that works too, as long as the sold property was hers as in (a).

In Op, all we are told is that wife had a big huge capital gain in 2021. Was the property (a) hers from the start, (b) hers by inheritance form husband, (c) hers by gift from husband, or (d) hers in some other way? What I'm getting at is the "predecessor" languabe cited above. There might be a plausible argument that H was predecessor in some of those, but not in (a), in my opinion.

I see that you're finally getting around to the point I raised in #5.

Not really, but I can see why some might think so. "There might be a plausible argument" is a far cry from absolute or definite. And the only absolute conclusion I've reached was one based on OP's facts in OP.

As I ponder this, and particularly given that no IRS reg. or other guidance exists even though the legislative history opened up a chance for them to write such guidance, I still would take the position that even scenarios (b), (c) and (d) give us the same result.

And I think they probably considered it, but made their decision because "predecessor taxpayer", as pointed out by Jeff-Ohio, typically has to do with an entity. I have not found a use of it in the context we are dealing with here or any similar context.

Now maybe a transaction without substance, or a step transaction, might yield an adverse result, but death is not rarely that.

Interesting discussion, but we're talking about a return position. You have plenty of support for not reporting a 1231 loss carryover.

What's a 1231 loss carryover ?

Sorry, wrong term. I was loosely referring to recharacterization of 1231 LTCG as OI.

Interesting discussion, but we're talking about a return position. You have plenty of support for not reporting a 1231 loss carryover.

I think most members who actually prepare returns (I'm not one) are asking for more than just a return position. They are aware of the various professional standards for reporting on a return and the various penalties that can apply to taxpayers and preparers. And, of course, the ethical responsibility not to take a position merely because it's unlikely to be examined.

Rather, they are looking for the "right" answers, defined with reference to all relevant authorities and with the understanding that there are very often no absolute answers - but often there are.

I see that you're finally getting around to the point I raised in #5.

I already addressed it. Quite a stretch to use the concepts of predecessor (taxpayers) and successor (taxpayers) in the case of natural persons.

I suppose your logic would necessarily mean that if my brother and I owned property JTWROS and my brother died in 2021 such that I receive his one-half by operation of law, then I am a successor taxpayer to my brother, who would be my predecessor taxpayer. Thus, if he has any non-recaptured 1231 losses in the 5-year lookback window, that would convert some of my 2022 Sec 1231 gain, from selling such property, to ordinary income. But tell us: Under your theory, if it wasn’t the inherited property that produced my Sec 1231 gain in 2022, but some other property I owned, would I recapture anything as ordinary? Surely your answer has to be “yes.” I mean, the decedent is either a “predecessor taxpayer” as to the survivor or he isn’t. That determination would be made at death. Why would it matter what property I sold in 2022? (And we wonder how your theory plays out when something passes through an estate).

And yikes! What if a Frank owned 10 properties, JTWROS. Prop #1 is between Frank and joint tenant #1. Property #2 is between Frank and joint tenant #2. And so on and so forth. What happens when Frank dies? Which of the 10 joint tenants succeeds to Frank’s non-recaptured losses?

So assume A and B are unrelated. A has big huge 1231 losses that he uses in 2019. Also in 2019, A and B do a 1031 exchange for like-kind, low basis, highly appreciated properties, even up, no debt, no boot. In 2023 (well within the 5 years of 1231(c)), B sells the property that he got in the exchange for cash at a big huge gain. I guess under NoCalCPA85's approach, seems A is B's predecessor, as B got the property in a tax-deferred exchange from A, who had those big huge 1231 losses, so B now has ordinary income from the gain on the sale. Especially since no one died.